Spot the Pattern and Let Me Lie to You

This is actually a post about two different lies.  The first is the lie your brain tells you because it can’t help itself.  The second is a lie investors need to keep an eye out for when presented with market data.

Spot the Pattern

We all know about the market cycle.  The market goes up.  The market goes down.  There’s a chart that’s basically a sine wave that starts with an upward trend, peaks, reverses, then goes down until it troughs and rebounds to begin the cycle anew.  The market is never that neat, though, right?

Okay, sometimes it is that neat.  This is a beautiful example of the S&P 500 starting in 1997 moving through the cycle.  The first euphoric peak is the tech boom in 2000 followed by the tech crash into despair.  The rebound peaked just before the global financial crisis sent the market back into despair.  After the bottom in 2009 there was a sharp rebound.  Are we at euphoria?  Is this the market top?  Complete the pattern.

Of Course This Is A Lie

The human brain seeks out patterns.  In this case it looks like the market bounces between an upper and lower range.  Someone (okay, me) has even added emotions to the roller coaster ride.  So is this the peak?  The chart only goes until the beginning of 2013 so let’s take a look at what actually happened.

The above is a chart from JP Morgan (because it’s prettier than my stuff) that reveals the lie.  Our brains seek patterns in all data, filling in the gaps for what came before and predicting what will happen next.  This works for many applications, but not in predicting the market.  Instead of a euphoric peak, 2013 was merely a midpoint in a massive bull run.  There is no pattern to the market’s returns.

This is All Garbage Anyway

Take a closer look at the two charts above.  They show the S&P 500, right?  Technically, yes, but they show the S&P 500 without dividends.  It’s forgivable in the JP Morgan chart which is actually a great comparison of the market environment through two nasty bear markets.  In my first chart, however, it is a devious lie of omission and one I look for on money manager marketing materials.  If I catch someone using the S&P 500 price returns rather than total returns (the one with dividends), it’s a HUGE red flag.

Why would someone leave out dividends when showing the S&P 500 as a benchmark?

• They want to make their numbers look relatively stronger.
• They are manipulating the data to fit their narrative.
• They are not sharing dividends with investors

Regarding the last point, I have seen multiple indexed annuities use the price index as a benchmark.  Benchmarking to a price index mutes what the annuity company has to credit to customers and provides them with some additional margin.

What’s an extra 2% anyway?

An investor who started with $10,000 invested in the S&P 500 and reinvested dividends would end up with over $7,000 more than an investor who didn’t get those dividends during the 15-ish years shown.  This is a staggering amount as just a little extra compounds over time, snowballing into real money.  It should also be noted that including dividends ruins my market cycle narrative.  Instead of a (more or less) sine wave, the red total return line diverges quickly as the absolute value of the portfolio outpaces the price return line.  So not only did I lie by cherry-picking the time frame, I also used a stripped-down version of a well-known benchmark.

It pays to watch how financial folks choose to present their data.  We should also remain aware of how we interpret that data and whether our conclusions are based in reality or by massaging that data to fit our preconceptions.